Activity based costing ABC is an approach that assigns costs to products or services based on the activities and corresponding resources that go into them. Activity Cost Driver establishes the relationship between activity and the cost.

Activity Based Costing involves following steps.

• Identification of activities involved in the production process;

• Classification of each activity according to the cost hierarchy (i.e. into unit-level, batch-level, product level and facility level);

• Identification and accumulation of total costs of each activity;

• Identification of the most appropriate cost driver for each activity;

• Calculation of total units of the cost driver relevant to each activity;

• Calculation of the activity rate i.e. the cost of each activity per unit of its relevant cost driver;

• Application of the cost of each activity to products based on its activity usage by the product.

Examples:

Plant Construction is an activity whose cost will be defined by the cost drivers like number of plants, scale, number of labour required or degree of work centralization.

Finished manufacturing products require testing. The cost of testing is depended on inspection hours. So inspection hours is a cost driver.